Describing himself as “still a bit surprised at how cautious and bearish some investors remain,” Calamos Senior Portfolio Manager Michael Grant says, “This is not normally the mood in which bull markets end.”
“There’s enough life left in this equity cycle to make money,” Grant noted at a recent meeting with financial advisors. “We anticipate a cyclical bear emerging later in 2018, but we are simply not there yet.”
Risk-on/risk-off positioning is a challenge for advisors, he acknowledged, as clients watch equities move higher.
“It’s better to be properly positioned before clients start to push for more aggressive exposure,” says Grant. “My suspicion is that, for the next six months, risk-on pressures from clients will dominate. And for now, the clients could be right.”
Grant reviewed the key points to his bullish outlook, first expressed in 2016:
- 2017 is the first post-crisis year that markets are enjoying the fundamentals of stable and synchronous global GDP. This is why the character of equity returns has become less volatile.
- Equities are taking their lead from the earnings cycle. As long as the year-over-year growth in sales and earnings is improving—which has been true since Q1 2017—market corrections are typically modest. The autumn months might see some consolidation, but sharp sector rotation is the greater risk, he said.
- The weak U.S. dollar is a meaningful tailwind. “If you look back to Q4 of 2016, dollar strength subtracted about 2 points from revenues for the U.S. corporate sector. In Q4 of this year, dollar weakness will add about 3 points to sales—an impressive swing of almost 5%.”
Global Recovery Independent of U.S. Politics
In November 2016, Grant described the election of Donald Trump as having “thrown fuel on the emerging embers of global economic reflation, a setting that was ripe for sustained recovery.” Despite Trump’s stumbles, markets have extended their post-election bounce, he says, because the global upturn actually commenced in summer 2016 and “had nothing to do with fiscal hopes.”
“The underpinnings of this global business cycle are firmer than you’d think if you just took your cue from political developments,” Grant added. That said, he believes the initial response to the election made sense because Trump swept the possibility of more regulation and more taxes off the table.
Trump’s election might be symbolic of the end of fiscal austerity as a dominant ideology for policy in the United States and in Europe. Grant notes, “While voters have a range of issues that they care about, the message of the election was that stronger and broader economic growth, for now, counts more than the others.”
In Grant’s view, the fiscal austerity of the past five years was “a forced and unnecessary error” by policymakers. “A genuine shift to fiscal stimulus as an underpinning of the economy’s potential could alter the contours of the investment setting in coming years,” he says.
Equity Valuations
Is the market overvalued? That belief is commonplace because price/earnings ratios are high on an absolute basis, Grant says.
“But valuation must be judged in the context of interest rates. Interest rates are like the gravity that anchors the behavior of other financial assets.”
He elaborates: “If you believed that interest rates would be 0% forever, you wouldn’t view a stock valued at 20 times earnings with a 2% dividend yield and a 5% growth rate as overvalued. You’d probably view that stock as attractively priced.” In this context, equities appear fairly valued, at least as long as rates remain below 3%.
And Grant notes: “Though the U.S. expansion is mature, much of the world has only just emerged from recession. The notion that this global recovery has been fully discounted by equities seems premature.”
The Key is the Fed
“If the Fed is successful—and we’ve often lived with the phrase, ‘Don’t fight the Fed’—we could enjoy several more years to this expansion,” says Grant.
While the Fed’s path to higher rates seems clear, “it seems incongruous that the Fed would look to slow the economy,” according to Grant. “Insofar as some of this country’s political tensions have been provoked by economic stagnation, one would assume little support amongst policymakers for a weaker economy.”
The key, says Grant, is to understand that “rather than stronger growth, [Fed] Chairwoman [Janet] Yellen’s objective is to make this the longest expansion on record.”
A robust economy that forced the Fed to tap harder on the brakes could lead to recession by 2019, Grant says. Instead, Yellen might prefer a subdued pace of growth if it translates into another five years of expansion. In this more benign scenario, the next U.S. recession might not appear until 2021.
Next: Corporate Debt Levels
But Grant expects the possibility of the next downturn, with the potential to drive equities down 20% to 30%, to take form in the second half of 2018.
It’s the corporate sector, which has meaningfully re-levered, rather than the consumer sector where Grant expects problems to emerge.
With the Fed set to raise rates through 2018, Grant says this will put steady pressure on corporate balance sheets. “To put this risk in context, corporate debt maturities in 2018 will almost double to $400 billion. The number will jump to $600 billion in 2019, and then perhaps $800 billion by 2020.
“If those maturities are refinanced at higher interest rates, which I think is inevitable, some corporates will struggle,” Grant says, “especially those that are highly levered and confront challenging industry dynamics.”
Today, there is little evidence of trouble as corporate bond investors continue to feed what Grant calls the “canaries in the coal mine”—heavily indebted businesses that will face deteriorating fundamentals under the weight of higher interest expense and industry competition in a slowing economy.
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© Calamos Investments
www.calamos.com
© Calamos Investments
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